Question

Consider the following information for stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Stock	Expected Return		Standard Deviation		Beta
A	7.25%		14%		0.7
B	8.25		14		1.1
C	9.25		14		1.5

Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

1. What is the market risk premium (r_M - r_RF)? Round your answer to one decimal place.

     %

2. What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.
3. What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

     %

4. What would you expect the standard deviation of Fund P to be?
   1. Less than 14%
   2. Greater than 14%
   3. Equal to 14%

   -Select-

Answer 1

Expected Return = Risk free rate + beta*Market risk premium

Using Stock A,

7.25% = 5.5% + 0.7*Market Risk premium

Market Risk premium = 2.5%

b.Beta of Fund P is equal to weighted average beta

= 0.7*1/3 + 1.1*1/3 + 1.5*1/3

= 1.1

c.Required return = 5.5% + 1.1*2.5%

= 8.25%

d. I. Less than 14%

since the stocks are not perfectly correlated, some risk will be diversified away